The PE: On its way out? For the Intelligent Investor, the PE emerges as the perfect tool to evaluate the degree of disconnect between the herd and reality.

August 31st, 2010

The Wall Street Journal strikes again! This time it’s an article entitled “The Decline of the PE Ratio.” And once again, it was too hard to pass up as a topic for this blog.

The first sentence alleges that the PE ratio “is shrinking in size and importance.” And it points out that, in spite of the fact that U.S. companies announced record profits during the second quarter—beating forecasts by more than 10%—the market dropped 5% this month.

It goes on to connect the dots, making the point that “the market’s average price/earnings ratio…is in free fall, having plunged about 36% during the past year,” and claiming that, because PEs have declined while earnings have risen, that the PE ratio may no longer be a reasonable metric by which to value the market. They’re absolutely right…if the market is what you invest in!

I submit that this article simply puts the cart before the horse and lets the tail wag the dog! (How’s that for mixing a barnyard full of metaphors!)

If the exercise is to analyze the market for the purpose of forecasting where it’s going next—a waste of time for my money, but a preoccupation of the herd—then they’re right in saying the PE has little importance. It never really did! Technical analysis, the tool of the market analyst, never could be  bothered with earnings, or the other fundamentals.  The market is driven by anything but company performance, as the article correctly point out.

However, for the intelligent investor who has only a passing interest in the meanderings of the market, the PE emerges as the perfect tool to evaluate the degree of disconnect between the herd and reality. The lower the PE, especially in the face of growing corporate earnings, the more obvious it becomes that the herd doesn’t understand the nature of investing, and the wider the abyss between the herd and those who understand what investing really is.

And the easier it is to find bargains out there.

To understand the real value of the Price/Earnings ratio, read What’s a PE, and What’s it to Me?

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Wall Street Journal

The Decline of the P/E Ratio

BY BEN LEVISOHN

As investors fixate on the global forces whipsawing the markets, one fundamental measure of stock-market value, the price/earnings ratio, is shrinking in size and importance.

And the diminution might not stop for a while.

The P/E ratio, thrust into prominence during the 1930s by value investors Benjamin Graham and David Dodd, measures the amount of money investors are paying for a company's earnings. Typically, companies that post strong earnings growth enjoy richer stock prices and fatter P/E ratios than those that don't.

But while U.S. companies announced record profits during the second quarter, and beat forecasts by a comfortable 10% ....